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PEER COMPANIES

By Somnath Mukherjee

Does the Reserve Bank of India (RBI) maintain excessive reserves in its balance sheet? Would transferring part of the reserves to the government be better use of the same?

The questions are at the heart of the polemical debate underway currently, and have both technical as well as philosophical moorings. At a philosophical level, there is the question of the independence of the central bank, as also an embedded principle of statecraft – “who is the sovereign”. Is it the elected government of the day, or specialized institutions entrusted with specialized policymaking mandates that have wide-ranging politicoeconomic effects?

To start with, the ostensibly easier question, the technical argument itself is complicated. Arvind Subramaniam, the previous Chief Economic Advisor (CEA) sparked off the debate a couple of years back in the Economic Survey 2016, when he compared RBI’s reserves with that of Central Banks (CB) across the world – the illustration showed that RBI is way above the average – and proposed using part of the reserves to recapitalize Public Sector Banks (PSB). As of June 2018, RBI has reserves of INR9.69 lakh crore, accounting for about 28 per cent of its balance sheet. A CB however, is not an ordinary bank. It does not derive its solvency from commercial banking standards. Technically, a CB could have its entire equity capital wiped out and still maintain its ability to honour its liabilities. This is because a CB is entrusted with the sovereign power to print money at zero cost (to be paid to the currency-holder). Indeed, there are perfectly credible analyses – including by practitioners like Prof Thomas Jordan of the Swiss National Bank – that conclude that even negative equity in a CB isn’t a hindrance to normal operations.

Critics of the proposal, however, say that a material reduction in RBI’s reserves will impair its ability to carry out its functions as a CB effectively. Some, including a former RBI Governor, have also likened reserves on RBI balance sheet as a “rainy day” capital. It’s useful to test the objections out – first with a look at RBI’s balance sheet.

RBI’s liabilities (see table) primarily consist of deposits (in most parts, non-interest-bearing Cash Reserve Ratio that banks have to mandatorily park with RBI, and interest-bearing reverse repo money) and non-interestbearing Currency in Circulation (CIC). Against this, the Asset side consists of Foreign Currency Assets (FCA) and GOI bonds, both of whom are interest-bearing instruments. The spread, also known in technical jargon as Seigniorage, enables RBI to basically earn profits out of thin air. Ergo, the argument that raiding the RBI balance sheet would result in weakening its ability to intervene effectively stands on weak ground. The “business” of RBI can be (and is) conducted via fiat – of changing reserve ratios, printing currency and changing interest rates – RBI’s income (and by derivation, reserves) are a function of such sovereign powers, that have little to do with relative size of reserves in the balance sheet.

What happens if RBI were to transfer 3.6 lakh crore of its reserves to the government (as is being speculated in the media, though the government has denied it since then)? Effectively, it would simply tantamount to RBI cancelling an equivalent amount of GOI bonds that it holds in its balance sheet. RBI’s balance sheet would shrink, though not to the same extent as part of the money spent by the government will find its way back into RBI’s balance sheet via the banking system.

The collateral impact of such an accounting exercise will be potentially on one key variable — inflation. A reserves payout causes an immediate reduction in balance sheet space available to RBI for its Open Market Operations (OMOs), via which it implements monetary policy and also supports its role as the public debt office. To surmount the problem, the easiest solution would be to print money (or loosen banking reserve, or CRR, requirements) – both of which would push down interest rates and potentially trigger inflation in the economy. There is some empirical basis – in a 2012 paper, Adler and Tovar of IMF and Prof Pedro Castro of University of California, Berkeley tested the hypothesis of CB capital and interest rates for 41 major economies. They found that CBs with lower capital are found to follow far more dovish monetary policy (read, lower interest rates) than CBs with higher capital base.

This leads us to a potential solution to the debate. Under the institutionalized Monetary Policy Committee (MPC) framework, RBI has a legislated mandate of “inflation targeting”. In other words, the government has legislatively mandated RBI to conduct monetary policy with a single mandate of targeting a level of inflation. As of now, that level is 4 per cent, with a +/-2 per cent tolerance band. If paying out a large, extraordinary dividend to GOI is potentially inflationary, RBI could simply ask GOI to change the target embedded – maybe to 5 per cent, or even 6 per cent. The level of inflation that is tolerable to the economy at a particular stage of development is undoubtedly a policy question to be answered at the level of the political executive. Like all policy objectives, this too has pros and cons – RBI could toss the decision back to GOI – what level of inflation would GOI be comfortable with for the incremental (say) 3.6 lakh crore of fiscal space afforded via reserves transfer? It makes for an analytical framework for what is today an emotional debate.

It’s a Shakespearean ‘To be or not to be” dilemma – but one that is better framed, and begs itself to potentially more rational debate, than polemics around sovereignty and independence.

(The author is the managing partner, ASK Wealth Advisors. The views and opinions expressed in this article are personal. )

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)